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The cost of living

Health care spending is higher than ever and still climbing. Why? And what can be done about it?

May 1, 2002


Douglas Clement Senior Writer

"April is the cruelest month," wrote T.S. Eliot, but for Anne Lundstrom, president of All Flex Inc. in Northfield, Minn., the most brutal time of year is late February, sometimes stretching into March. That's when she and her 40 employees sit at their desks, pull out their pens and start to fill out stacks of health insurance applications. They've done it every winter now for four years. "The whole process gets to be quite tedious for people. And for my human resource people—well, it's very painful," said Lundstrom. "But you have to do it if you want to get better rates."

All Flex, a manufacturer of flexible printed circuits, pays every penny of its employees' health insurance premiums—"to be competitive in the industry, we have to," said Lundstrom—and rate increases have a strong impact on the company's bottom line. Premiums rose 12 percent in 1999 and another 12 percent in 2000. Last year, premiums were set to rise 40 percent, so everyone filled out another set of applications, the company sent them out for bids, and they tracked down a new insurer who quoted a lower price for 2001, "just" 20 percent higher than 2000 premiums.

In 2002, same deal: new set of applications, new round of bids and a new search for an affordable health plan. "Somebody will have a slightly lower rate, and we'll switch to them," Lundstrom predicted. "But it's very disruptive to the employees every single year to have to go through this long drawn-out process." Lundstrom says it's kind of surprising that they always find one insurer with a significantly lower rate, since they provide the same information to all companies. "I think it's because they want to get the business. They're out for more market share, I imagine." But if experience is any guide, she said, this year's low bidder will be next year's unaffordable health plan.

As a small employer with limited leverage, All Flex probably faces bigger premium hikes than the average corporation, but the trend it faces is the norm, not the exception. And while insurance companies inevitably jockey for market share—with industry premiums cycling down to gain customers and then up to recoup costs—the general trend of climbing premiums reflects a universal rise in the underlying cost of providing health care.

Throughout the country, health care expenditure is climbing at a rate far exceeding that of inflation, placing a strain on company payrolls, government budgets and individual wallets. The last time health care costs were climbing like this was in the early 1990s and the Clinton administration responded with an ill-fated attempt at health care reform. Health care expenditure stabilized for a time in the mid-1990s—as managed care ushered in a short-lived phase of cost-control—but expenditure is now rising again as both providers and patients have rebelled against the diminished choices that managed care companies tried to impose.

As a nation, we spent $1.3 trillion on health care in 2000, 6.9 percent more than the year before. The figure represents 13.2 percent of gross domestic product (GDP), approaching twice the 7 percent share spent in 1970 and higher than any other industrialized nation. By 2010, it's projected the nation will devote 16 percent of GDP to health care and, says the 2002 Economic Report of the President, the figure could eventually reach 38 percent of GDP "under conservative assumptions."

Why are costs climbing and what can be done?

To some degree, the problem and potential solutions can be analyzed through the tools of elementary supply and demand, the traditional means of understanding markets for any product, be it shoes, wheat or angioplasties. The factors that influence demand for health care and its supply have had a strong impact on recent price trends and some of those factors are amenable to policy intervention.

Demand: technology and aging

Two key factors are behind the surge in demand for health care: technological change and aging of the population. These aren't the only factors, of course, but they're among the most significant.

The last two decades have seen a massive increase in new medical technology—from arterial stents and cardiac defibrillators to diagnostic tools like computed tomography and genetic screening—and each of those technologies created a major new market and a tremendous surge in spending. Even getting something as "basic" as a knee replacement costs about $20,000 in hospital fees alone, and the number of such knee operations has increased sixfold over the last 20 years. And with each passing month, the Food and Drug Administration (FDA) approves a new technology to address an old ailment.

In January 2002, for example, Kay Wisneski of Green Bay became the first person in Wisconsin to swallow a capsule containing a tiny wireless video camera. "At the end of the day," she reported, "there were over 58,000 pictures of my insides." Not a pretty sight, maybe, but for Wisneski it was a blessing. For over three decades, she's suffered from a painful inflammatory bowel illness called Crohn's disease and though the camera-in-a-capsule can't cure the inflammation, it makes diagnosis and treatment more accurate and less painful.

But the financial pill is hard to swallow: The single-use capsule costs $450, not counting the doctor's time and the high-tech machines needed to receive, process and display the images of Wisneski's inner being. Future versions of the capsule might include a built-in motor, and tiny blades or lasers for microsurgery. Fantastic stuff, but it won't come cheap.

Pill pushers

A subset of the new technology—one that draws both positive and negative attention—is pharmaceuticals. Recent attention has focused on prices. For example, in late February, Montana's attorney general sued 18 drug firms, accusing them of illegally inflating prices.

But perhaps more important is the issue of quantity. According to most studies of rising drug expenditure, higher prices account for less of the jump in total cost than do greater quantities purchased. Last year alone, the number of prescriptions grew 6.6 percent, to 3.3 billion.

And why are we popping more pills? In part, because new drugs like Viagra address previously untreatable problems. But a major pump behind rising demand is marketing by pharmaceutical companies. Drug company spending on direct-to-consumer advertising has soared from $859 million in 1997, when the FDA loosened ad restrictions, to nearly $2.5 billion in 2001. Critics have called this advertising excessive, saying that pharmaceutical firms spend more on advertising than on research and development. The advertising is definitely effective in raising brand awareness; whether that's good or bad may depend on one's perspective.

Fifty-two percent of physicians surveyed by the Minnesota Medical Association in summer 2000 said they had felt pressured by patients to write prescriptions for advertised drugs even though they felt the drugs were unnecessary. Sixty percent said encounter time with patients is increasing because of direct-to-consumer advertising. On the positive side, physicians noted that patients seem more aware of risk factors and that advertising leads patients to contact their physicians sooner.

Growing up

The second fundamental factor in health care demand is age. The number of Americans aged 65 or older went up 11 percent from 1990 to 2000. By 2020, according to the U.S. Census Bureau, the percentage of the population 65 and older will rise from 12.6 percent to 16.5 percent. Several Ninth District states are ahead of that aging curve. In Michigan and North Dakota, the proportion of the population 65 and older grew 40 percent from 1990 to 2000; Montana saw 10 percent growth but will see far more in the future. Current projections are that the number of Montanans aged 65 and older will grow from 133,000 in 2005 to 209,000 in 2020, over 57 percent growth.

Since the older use far more health care than the young, the implications for health care demand are enormous. The medical spending of 55- to 64-year-olds is almost twice that of 35- to 44-year-olds. And those aged 65 years and older, though they comprise just one of eight Americans, account for over a third of total health spending. As the population of district states ages, the demand for medical services will inevitably climb.

... and supply: too little labor, too much waste

In the face of climbing demand for health care is a supply curve with its own set of problems. One of the more significant is a labor shortage. Another is medical fraud. Waste and malpractice insurance are still other factors that influence the supply curve. Together, these factors increase the cost of doing business and those costs tend to get passed along to customers.

Health care systems in the Ninth District suffer significant labor shortages. Nurses, in particular, are in high demand. Shortages of dentists, pharmacists, radiologists and a number of other medical subspecialties are also widespread, and district hospitals have been scrambling to find workers. [See also "Rural health care".]

Jim Aherns, president of the Montana Hospital Association, said personnel shortages "affect almost all of the health care professions" in Montana and many neighboring states, and they're particularly serious for nurses, pharmacists and lab technicians. The solution, he said, includes better educational programs and higher wages. As if to underline the latter point, Great Falls' Benefis Hospital, the state's largest, raised its rates 8 percent this year, saying that the hospital has had to give nurses and radiology technicians raises to keep them from leaving.

In South Dakota, the 2002 Legislature funded a tuition reimbursement program for nursing education to address what state officials view as a severe shortage, but advocates acknowledge the bill—which offers up to 60 nurses no more than $5,000 each—is a small, longer-term effort. Shortages of nurses in Minnesota gave the Minnesota Nurses Association (MNA) significant leverage in its salary negotiations in 2001, and the negotiated pay hikes have had a "ripple effect" at hospitals elsewhere, according to the MNA Web site.

The ripples are being felt in the upper reaches of health care as well. Signing bonuses for cardiovascular surgeons are as high as $500,000 in Sioux Falls, with $1 million salary guarantees for two years, according to Michael Myers, a professor of health services administration at the University of South Dakota. As South Dakota competed in the national market for specialists, average salary offers to radiologists jumped from $225,000 in 1999 to $271,000 in 2000.

The rising price of malpractice insurance is one factor that drives physicians from the trade, dissuades those who consider entering it and raises the costs of those who stay in business. Jury awards in malpractice suits have climbed in recent years, forcing insurers to raise premiums. The average increase was 10 percent last year for internists and general surgeons, but some parts of the country saw 86 percent jumps. Even with the premium hikes, Minnesota's St. Paul Cos., the nation's second-largest malpractice insurer, decided in December 2001 to phase out of the business entirely.

Diagnosing for dollars

Supply curves for medical care are significantly affected by fraud. According to a widely quoted 1992 General Accounting Office report, health care fraud and abuse account for about $100 billion a year, nearly 10 percent of total health care expenditure. Other fraud investigators peg the figure closer to $250 billion, but the fact is no one really knows the total.

Some analysts predict that physician shortages will grow worse; Richard Cooper at the Health Policy Institute of the Medical College of Wisconsin estimates that the United States will have a shortage of 50,000 physicians by 2010. The number of applicants to medical schools has dropped 26 percent since 1996, and the number of applicants to residency programs in general surgery has dropped 30 percent over the last nine years.

Fraud can include kickbacks, "upcoding" (billing by providers for a more expensive service than was actually provided), charging for services not ordered and "unbundling" (charging insurers for many individual tests rather than for an agreed-upon "bundled" discount). During the 1990s, the FBI devoted more agents to fraud, and the number of active health care fraud investigations grew from 592 in 1992 to over 3,000 in 1999. Convictions rose from 116 to 548 in that period.

Spurred by a federal inquiry into alleged overcharges to Medicaid by Allina, one of Minnesota's largest integrated health networks, the state's attorney general launched his own investigation, and in March 2001 he filed suit against Allina, alleging that 47 percent of the company's insurance premiums went toward administrative expenses, including millions spent on perks like golf outings and Waterford crystal.

Allina disputed the charges, but eventually agreed to major changes, including a split-up of its insurance and provider operations and replacing its board of directors and top management. Separately, Allina spent nearly $20 million to dispose of US Justice Department claims of overcharging.

Wasting away

Another factor behind climbing costs is waste associated with medical practices that are unwise or unnecessary. Unfortunately, doctors are often unaware of the best treatments, let alone the most cost-effective. "There's enormous disagreement among the care providers themselves," noted Kay Unger, professor of health economics at the University of Montana at Missoula. Even well-informed doctors presented with a given diagnosis will show "a wide variation in what the appropriate treatment is." And when experts do reach consensus on a best practice, it often takes years for the entire profession to adopt it. For example, beta blockers were shown over a decade ago to significantly increase survival rates after a heart attacks. But in 2000, nearly half of heart attack victims still didn't receive them.

Chart-Health care spending by category, 1998

The wide variations in medical expenditure among different US geographic regions demonstrate that significant sums are wasted on unneeded health care. Per capita Medicare spending in Miami in 1996 was nearly two and a half times that in Minneapolis, according to a recent study, even when differences in age, sex and race were taken into account. Pricing levels couldn't explain the variation, nor could disease differentials.

According to the study's authors, Miami doctors and patients simply chose more treatments and more expensive treatments than did those in Minneapolis, and the additional spending had no discernible impact on health outcomes. Bringing treatment down to the level of the low-cost regions of the country would save $40 billion, concluded the researchers.

Without unanimity about—and adoption of—best medical practices there is significant economic waste. But bringing that about is a major challenge, demanding better information systems, improved medical education and incentives to encourage efficient care.

Making policy

Faced with this litany of problems, policymakers in Ninth District states are looking for answers. Montana's governor has appointed a labor shortage task force to research the problem and develop recommendations for the 2003 Legislature; a similar task force is looking into insurance coverage troubles. Michigan's governor sought greater state control over the nonprofit Blue Cross Blue Shield after a recent audit found that the state's largest health insurer was in precarious financial shape. The state is also negotiating price discounts from pharmaceutical firms.

Minnesota, like Montana, has a health policy task force considering problems and options in advance of next year's legislative session. South Dakota has tried to encourage health workforce growth by increasing funds for nursing education and limiting doctor liability. In Wisconsin, legislators have considered limiting hospital rate increases and prohibiting new hospital construction.

All of these task forces and initiatives will have to cope not only with the basic issues of supply and demand discussed above, but with a host of more vexing complications, that discourage even seasoned health policy experts. [See "Beyond supply and demand".] "History suggests that it may be folly to expect that there are any easy or magic answers to this problem," wrote health care analysts Drew Altman and Larry Levitt in a January 2002 commentary. After reviewing the inability of private and government efforts over the past 40 years to permanently curb growth in health care spending, they concluded that "the apparent failure of all approaches reflects the American people's uncontainable desire for the latest and best health care, and [suggests] that what we will do in the future is try small things that will work at the margin, complain a lot, but ultimately pay the bill."


Douglas Clement
Senior Writer

Douglas Clement was a managing editor at the Minneapolis Fed, where he wrote about research conducted by economists and other scholars associated with the Minneapolis Fed and interviewed prominent economists.